Why are short term bonds a better hedge in bad times and how is it negatively correlated?
Shorter-dated bonds are a better hedge for bad economic times because they are less sensitive to interest rate risk. If you are holding shorter-dated bonds during bad economic times, then it is more likely that you will realize the YTM because you would probably be holding them to maturity, rather than selling them at a later date.
However for longer-dated bonds, you likely will not be holding the bonds for the entire 10, 20, or 30-year tenor, you are more likely to sell them prior to maturity, but interest rate risk comes into play because it would affect the price you would be selling that bond for, which ultimately affects the return you can realize on that bond, thus making it a poorer hedge against bad economic times versus short-dated bonds.
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@AKRapoza Thanks a lot. Could you also please explain how short-term bonds are negatively correlated?
They are “negatively correlated” with bad economic times because of the points I made above.
So in ‘bad economic times’, markets tend to de-risk. This means move from assets to cash and move from longer to shorter duration bonds.
So move away from equities and towards bonds, in particular ‘riskless’ bonds (ie govvies
Classically,. on negative tail events, you see short term govvies spike up as accounts move towards safe havens. This is why they are negatively correlated.
Yes and No.
You are correct that is what happens but the module wants to you think why and what causes the shift.
Why do people make the shift you are talking about.
They make the shift becuase the long end has more risk, returns at the long end are worse in bad economics times and therefore offer a poor hedge against it all going Pete Tong.
Short date bonds contain less uncertainly (purely by the fact they are shorter and less things can go wrong) and so offer a better hedge against bad economic times.
To be this is one of the worst readings in the whole of the CFA. It has taken something we can funamentally understand, tried to theorise about in and made incomprehensible and to try and add credibility to it they have stuck in some equations and the ITRS. Who in their right mind though the first half of this readiing lives anywhere but in an academics head, and the sort a academic who sits on their own at the xmas party and trying to find a equation to explain why they have no friends.